One of the most controversial contracts that resides in Malaysia is the Bai Inah contract. For many years, Malaysia have been taking heat on its use from international forums. The major reasons for this critique is that Bai Inah, while having an underlying transaction in its structure, argues critics, smells suspiciously like a loan with interest. There have been many opinions to this, but I must admit that each argument has its own merits and rationale, and it is difficult to draw the line here.
But before going further, what is Bai Inah? Why is it always under the Islamic finance microscope for scrutiny? Why are feathers always ruffled when discussing Bai Inah?
Simply explained, Bai Inah is a simpler, flip version of Murabaha. It involves an Asset, which is purchased from a third party, owned and sold to another party at a profit for deferred settlement. While Murabaha involves the Party A buying an Asset from the Supplier and on-selling the Asset to Party B at profit and deferred settlement, Bai Inah happens when Party A, who is already an owner of the Asset from a supplier, then on-sell this Asset to Party B, and Party B not wanting the Asset, re-sell the Asset to Party B (Agency) and collects the proceeds.
The purpose of both structure is to create debt, and under both structure, cash can be obtained, therefore Bai-Inah can also be used to procure Assets. Also, Bai-Inah is a key component in a re-financing scenario; a customer has fully owned a property but now requires cash or capital, sells the property to the Bank for cash, whom then re-sells the property to the customer at a profit to be settled via instalments.
In a nutshell, Bai-Inah (to a similar extent, the Bai Bithaman Ajil contract), is a contract where only 2 parties transact between them to create a debt. This is argued to be not a real transaction but a “trick” (hilah) to circumvent the creation of profit from cash.
The Central Bank of Malaysia (BNM) therefore issued a clarification on 2012 on how Bai Inah must operate, without going to the extend of saying the contract is invalid. It is not invalid, this much is clear, so long as certain rules are adhered to. The single main issue is on interconditionality for Bai Inah which must be addressed to continue offering the product.
What is “Interconditionality” in a contract?
Interconditionality exists in almost all the legal documents for financing, be it Ijara, Murabaha or Istisna’a. Interconditionality means that if a certain event happens, a clause or an effect is activated to rectify the event. Interconditionality means that no contract is independant from each other, there is explicit link between one action with another action and it can even be sequential linkages. For example, a Murabaha may have an interconditionality clause that the Bank must FIRST purchase an Asset from a Supplier BEFORE selling it to the Customer. Sequentially this must happen to ensure that the Sharia requirements are met.
Or an Ijara may also have a condition that should the Customer decides to terminate the lease i.e. vacate the property, there is an undertaking that the Customer must purchase / settle the existing equity on the property, and the Ijara agreement will not be executed until this undertaking is obtained.
For Bai Inah, the interconditionality happens when the Bank impose on the Customer that the Bank will only Sell its Asset to the Customer IF the Customer agrees upfront to Re-Sell the Asset back to the Bank. Failure to do so (the Re-sell of the Asset) will result in the first sale to be invalid. This is captured in documents for the purpose of ensuring the Assets are re-owned by the Bank at the end of the transaction.
BNM, based on discussions with Sharia scholars, has requested that this interconditionality be removed from Bai Inah documents (and to a larger extent, the Malaysian version of the Bai Bithaman Ajil). This attempts to ensure that Bai-Inah no longer becomes an “arranged” transaction just to validate the creation of debt.
However, there is huge confusion in the industry. What documents are there that says interconditionality is identified, and therefore can be removed? Some say the documents must be differentiated into 2 separate contracts. Others say the wording in the legal documents and customer forms can solve the problem. There is also a sizeable group that believes that they are not required to do anything; that they are already compliant to the requirements.
But for me, interconditionality is dependent on the Asset used for the transaction. So long as the Bank has “Interest in the Asset”, interconditionality can never be removed, no matter how beautiful your legal documents are designed.
So, what is “interest in the Asset”?
Under Bai Inah, the original owner of the Asset has explicit interest to re-purchase the Asset from the buyer the second the Asset is sold. Therefore all documentation and product design is based on this premise; protect the original owner’s right to the Asset at all costs. This means, the buyer (or temporary owner) really has no intention to purchase the Asset, or has no rights to hold/keep the Asset.
The key to removing interconditionality is to remove the Seller’s interest in the Asset.
If the Bank has no interest in the Asset, the interconditionality won’t exist. Why? The Bank can transact any type of valuable Asset and on-sell it to the customer. The customer owns the Asset. Therefore the customer has choices on what to do with the Asset. The options are : Use the Asset for the customer own use; or customer sells the Asset into the market to obtain cash; or appoint a 3rd party as an Agent to dispose the Asset on the customer’s behalf.
If the Bank has specific vested interest in the Asset, the documents will require that the Asset be sold-back to the Bank in a 2nd contract, failure of which will render the 1st contract invalid. Specific legal clauses are built to protect the Bank’s vested interest in the Asset. This effectively links the 1st and 2nd contract together; without one, the other is invalid.
The intention of including an “interconditionality” clause into the documents is not to spur any economic activity other than debt creation. There is no intention of Asset sale or any movement of ownership as the Asset, i.e. no real economic activity is done for the creation of the debt. The clause is created to create a legal obligation for the customer to re-sell back the Asset only to the Bank. Removing this legal clause is therefore deemed as removing the “arranged” transaction to create debt, but instead move it to potentially becoming a “valid” transaction involving an Asset as the underlying, resulting in a debt.
The key consideration to remove interconditionality is to make the arrangement into 2 separate AND totally independent contracts. Effectively, it must be a “Murabaha” AND “Musawama” arrangement. The first contract is for the owner of the Asset to sell the Asset to the buyer at a cost + profit to be settled on deferred basis (Murabaha). Now that the buyer has full ownership of the Asset, the buyer has the choice of either on-selling or keeping the Asset. This choice must be given to the buyer.
The key is to sell an Asset which has no value or interest to the Buyer. Bear in mind, the debt between the Seller and Buyer has now been created at this point. The Buyer has obtained the Asset (and no cash) and has an outstanding debt with the Seller. The debt needs to be settled and the Buyer owns an Asset they didn’t want.
Therefore, it is in the best interest of the Buyer to on-sell the Asset to obtain the cash required, and make the instalment payments. Naturally, the original Seller would make the offer to re-purchase the Asset to immediate settlement for the Buyer to obtain cash. To ensure this happens, all the legal ring-fencing happens.
Why Tawarruq / Commodity Murabaha works?
The alternative where a lot of practitioners are moving is Commodity Murabaha (Tawarruq). The transactional process is similar with the Bai-Inah structure. However the major difference is the Asset used. In Tawarruq, the Asset used for the Sale and on-sell is not of any interest to any of the parties. The Assets are market commodities; quite useless on its own and only valuable to the users of the commodities. For example, while Palladium sounds quite exotic, having ownership of 500kg of the stuff means nothing to a Buyer, unless he’s into precious metal industries and if he was, he’d buy directly wholesale. No point going through a Bank; the financing rates itself would not be worth it.
And even if the Buyer really wanted to keep ownership of the Asset/commodity, the Seller would have absolutely no interest to re-purchase the Asset, thus removing the need to have interconditionality clauses. Let the Buyer keep the commodity; the debt has already been created.
I don’t believe interconditionality can be removed simply by re-engineering your documents, or even by separating the documents or ensuring the option to take delivery of commodities. No, interconditionality is removed by way of deciding to transact on the right Asset or commodity that neither party has any interest in keeping. Having interconditionality clauses simply confuses the purpose of the transaction, which is debt creation.